Christine Benz: It's no secret that many state and local municipalities are in dire financial straits. So is it time to shun munis or could there be opportunities in municipal bonds?

Here to discuss that question with me is Morningstar's associate director of fund analysis, Miriam Sjoblom. Miriam, thanks for being here.

Miriam Sjoblom: Thanks for having me, Christine.

Benz: So what do you think about this question, Miriam? There are certainly a lot of scary headlines out there about what's going on with the state and local governments' budgets. Is it time to shun municipal bonds or do you think there are some opportunities there, potentially?

Sjoblom: I don't think it's time to shun munis. I think, a lot of the headlines that you read about are bit overblown. They focus on issuers that have had problems well before the recession: things like the State of California; their budget process has always been a highly partisan process that's involved a lot of wrangling, so it makes kind of scary headlines, but in reality the concerns are not as great for bondholders.

Benz: So muni default rates have historically not been super high. Do you think that past history is a reasonable guide to what one might expect from municipals in the future?

Sjoblom: Yes, I certainly don't mean to suggest that municipalities are just as healthy as they ever have been. It's a really tough environment out there. It's the worst environment in many decades, and I think, many managers that I talk to are pretty much in agreement that defaults should be higher. I think, you're going to see them in more places where you'd expect to see them. One area, Florida land-secured bonds for instance. It's not necessarily going to be a surprise where you're going to see them, although some local governments have really had a hard time and there have been some bankruptcies.

Benz: So it seems like one way to mitigate that municipality-specific risk is to opt for a fund, and that's something I would recommend. I assume that you agree with that rather than going it alone and picking off individual muni bonds.

Sjoblom: That's right. I mean, in this kind of environment you really don't know, as an individual investor, where the trouble is going to hit. It's best to go with a management team that has a really deep research staff that has been looking into these issues for years, and can spot trouble in advance. This is their full-time job to be adding that extra scrutiny.

Benz: So this state-specific versus national question is one that muni investors often think about, so should they go with a fund that is broadly diversified across the U.S. or one that focuses on their home state, and then maybe they can pick up that state tax exemption. What's your thought on that question?

Sjoblom: Well, I think, it depends on the state you're talking about. I think, there is a lot of concern about California. But California has still got a very vibrant, diverse economy, and it's one of the biggest issuers in the market, so not just the state, but all the local governments and various revenue bonds. So there are a lot of choices for fund managers to choose, be very selective in California, and still have a very broadly diversified portfolio. So that's when I wouldn't be so concerned.

For a state like Michigan, that's been in some real long-term difficulties, maybe that's an area you might consider adding some diversification with a national offering or maybe not just putting all your money in that state.

Benz: ...In that Michigan-specific fund.

Okay. So in terms of shopping for municipal funds, you mentioned experienced management being a big priority. You also talked to me, Miriam, about the pitfalls of shopping on yield alone, and I know that's something that muni investors are often attracted to, when they see the highest yield, they sometimes want to opt for that fund, but you think that's risky.

Sjoblom: It's particularly risky today because it's so tempting. Absolute yields are low across bond sectors, not just munis, but certainly for munis, too, so it's particularly tempting to go and choose the highest-yielding fund, but you really have to be careful about how that fund is getting its yield. You really don't get extra income without taking on more risk. And there are some techniques that managers use say using derivatives called inverse floaters, which are really an internally leveraged security that add leverage and volatility to a portfolio. So that's something to take a really close look at, where your fund is getting your yield from, and maybe be a bit skeptical of the highest yielding funds in the category.

Benz: Lastly Miriam I'd like to talk about what some of your favorite funds are for muni exposure?

Sjoblom: Well, we've always been big fans of Fidelity's muni funds, and there was even a recent manager change--Christine Thompson, who had run that team is now the CIO of Fidelity's entire bond group, but she has left the muni team in really great shape, and Jamie Pagliocco is now the head of the muni managers there.

One, if you have a long time horizon you might want to consider Fidelity Tax-Free Bond particularly if you're concerned about higher taxes, because that one is not exposed to alternative minimum tax, so – but it's got more interest-rate risks, so you have to be willing to hold on through some volatility as a result of that.

So if you want a little less interest rate risk you might choose Fidelity Intermediate Municipal, part of the same family, but just less volatility as a result of interest rates.

Benz: Okay. Well, thank you, Miriam. Thanks for sharing those picks as well as your insights on this sector. We appreciate it.